US hedge fund Long-Term Capital Management was all but destroyed by the impact of an announcement made by Russiaâs central bank early on Monday August 17, 1998, in a development that nearly sent the global financial system up in flames.

The bank chairman, Sergei Dubinin, said Russia was suspending payments of its ruble-denominated foreign debt due to a deteriorating economic situation.

The news caused LTCM, founded in 1994 by Salomon Brothers bond trader John Meriwether and whose partners included Nobel prize winners Robert Merton and Myron Scholes, to lose money that day on the position it had built in Russian Government bonds, despite having tried to put in place a hedge or offsetting trade.

But the real damage began to be felt that Thursday when, after three days of thinking about it, investors realized that a nuclear power and member of the United Nations Security Council had started defaulting on its sovereign debt. A flight to quality began that day that brought LTCM to the brink of collapse within five weeks.

LTCM had made double-digit returns over the course of four years following a strategy, still widely used in the hedge fund industry, known as relative value arbitrage.

It involves taking offsetting positions in two related securities, such as government bonds of similar maturity, whose prices appear to have gone out of line with each other—LTCM developed its own computer models to help identify such opportunities. The arbitrageur buys or “goes long” the cheap one, sells or “goes short” the dear one and waits for their prices to converge.

The price differences are small, so arbitrageurs typically try to magnify their returns by using leverage. LTCM was using a leverage multiple of more than 30 in early August 1998, financing a portfolio valued at $125bn with a fund of $4bn and borrowings of $121bn.

LTCM’s leverage would have been considered high at the time, had anyone apart from its bankers known about it. Relative value arbitrageurs now typically use a leverage multiple of two.

LTCM generated returns, net of fees, of 28% in 1994, 43% in 1995 and 41% in 1996—fabulous returns by the standards of the time and today.

They were all the better for having been achieved with low volatility and few loss-making months, and appeared to vindicate the firm’s initial investors who, between them, gave it $1.3bn at the outset, an unprecedented amount for a start-up hedge fund. Meriwether gave back $2.7bn to investors at the end of 1997, to their chagrin at the time, as they were hoping for better returns.

But Meriwether had given the money back because he and his partners were worried about their ability to maintain this performance. The fund had generated a net return of 17% in 1997, five percentage points below the return on the S&P 500 stock index. Returning capital had the effect of increasing leverage from a multiple of 18 to 28 at the end of 1997.

The firm also tried to maintain returns by continuing a program of expansion it had begun that year, broadening its focus from the government bonds of the G7 developed countries, to include corporate bonds, emerging market government bonds and equities.

As part of this expansion, it took positions in Russian treasury bonds, Brazilian bonds, Danish mortgaged-backed securities and other exotic debt securities. It felt the need to do this because its original specialty was running out of juice, partly through increased competition as others learned how to work the same trades. But LTCM’s exposure to G7 government bonds never fell to less than 80% of its total portfolio.

In August 1998, the fund had about 60,000 trades on its books, including long securities positions of more than $50bn and short positions of an equivalent magnitude. Its position in the futures market had a notional value of $500bn, representing more than 5% of the global market. Its swaps contracts had a notional value of more than $750bn, and its options had a notional value of more than $150bn.

Almost all of LTCM’s positions were intended to offset one another and were designed to take advantage of the convergence of prices, or a narrowing of yield spreads in the case of bonds—something the firm was sure would happen, just like it had before. The flight to quality that began on Thursday, August 20, triggered by Russia’s debt moratorium three days earlier, kicked these hopes into oblivion.

As in today’s credit crisis, investors in 1998 abandoned all but the lowest-risk, highest-liquidity bonds, causing a widening of yield spreads—the opposite of what LTCM wanted.

Nothing in LTCM’s models had made adequate allowance for this. The models implicitly assumed continuous pricing and liquid markets, both of which disappeared for many of the firm’s positions. They also assumed price changes and other financial events fitted the familiar bell curve of the normal probability distribution—a false assumption that remains widely used.

LTCM’s situation was fatally exacerbated by its leverage and size.

As soon as the value of its positions fell below a certain amount, its lenders, which had been using the positions as collateral for their loans, asked LTCM for more collateral, in the form of cash. In practice, this meant selling some of its positions. But LTCM’s size in some derivatives was so dominant that every other market participant—most of whom had lost money to LTCM at one time or another and detested its arrogance—quickly realized it was trying to sell and lowered their offer prices.

LTCM lost $1.8bn in August, about 50% of its value.

Hoping to keep going, it began looking for an injection of capital. It still had not done so by Monday September 21. Its lenders, which in most cases were also significant market participants, were feeling worried as well. The fund was within 48 hours of defaulting.

The scale of its debt alone was enough to put its lenders in jeopardy.

It was potentially disastrous that some of its lenders were also participating in the same markets as LTCM, because a forced sale of LTCM’s assets would lower the market price and oblige those lenders to write down their positions. This possibility was enough to start regulators worrying about financial stability.

On Tuesday September 22, a core group of four of the most concerned counterparties began exploring a recapitalization of the fund. Separately that morning, investor Warren Buffett, insurer AIG and Goldman Sachs approached LTCM with an offer to buy out the partners for $250m, inject $4bn into the fund and run it as part of Goldman Sachs’ proprietary trading desk. LTCM rejected the offer.

That afternoon, the Federal Reserve Bank of New York provided the facilities for the core group of four counterparties to encourage others to join them and they thrashed out a proposal: writing down the original owners’ stake to 10% and handing the remaining 90% stake, together with operational control of LTCM, to the consortium. This would be done in return for an injection into the fund of $3.6bn, approximately equal to the loss suffered by the hedge fund’s investors.

By the end of the next day, Wednesday September 23, a total of 14 counterparties had agreed to take part.

The only Wall Street bank not to participate was Bear Stearns, despite the fact that, as prime broker, it was possibly more exposed to LTCM than any other counterparty.

This purely self-interested decision cost Bear Stearns and James Cayne, then its chief executive, dearly almost 10 years later, when none of the other banks would lend it money to help it out of the credit crisis, forcing it into the arms of JP Morgan at a bargain price—again, with the encouragement of the New York Fed.

Following the LTCM bailout, losses continued to mount over the next four weeks, and many of the banks that had rescued it announced losses of their own in October as a result of having tried to copy LTCM’s strategy. UBS suffered the worst losses at $700m and its then chairman, Mathis Cabiallavetta, and three senior executives resigned, in yet another parallel with the current credit crisis.

LTCM remains the benchmark of hedge fund disasters, despite being beaten in size by Amaranth Advisors, a US hedge fund that lost $6.5bn in 2006, and other, more recent collapses such as that of Sowood Capital in the US and Peloton Partners in the UK.

The subsequent disasters had less effect on the financial system, mainly because of lower leverage, but also because they and the banks had far fewer trading positions in common.

The losses incurred by LTCM pushed the hedge fund industry’s returns in late 1998 to their lowest level since records began, in 1990, and they have never again been so poor. The debacle left the public thinking of hedge funds as high risk investments, even after the insolvency of individual public companies, such as Enron and WorldCom, that each caused losses many times the size of LTCM’s.

Despite the bad publicity, the hedge fund industry has grown apace in the past 10 years, with many firms being launched.

Among them is JWM Partners, founded in 1999 by LTCM’s founder Meriwether and five of his senior colleagues there.